Over the summer, a new design of Tube trains was blamed for a considerable increase in the number of passengers falling into the gap between the platform and the carriage at Tube stations across London.

For investors, there are a number of such day-to-day hazards to avoid in the search for long-term investment opportunities.

As an industry analyst performing in-depth research on individual companies and the sectors in which they operate, part of my analysis includes the close study of companies’ accounts. These accounts can be highly revealing, but they can also be misleading, and there are a number of pitfalls to be wary of.

One of these is the divergence between pro-forma earnings and GAAP (generally accepted accounting principles) earnings,[1] which we have noted as an increasing phenomenon.

As a case study, I looked at the pharmaceutical companies on our ‘research-recommended list’ and found that the price-to-earnings (P/E) ratios as stated by GAAP were some 8% to 87% higher than the pro-forma equivalents. This is a considerable difference, and it is clear to see how it could be potentially misleading.

How do we, as investors, avoid falling between the gaps? Which earnings measure is a better guide to the ongoing earnings potential?

Both have limitations. GAAP earnings, an attempt by auditors to standardise the definition of underlying profits, are calculated under strict guidelines, which may be too conservative in some cases. Conversely, pro-forma earnings, an attempt by management to give a ‘truer’ picture of underlying profits, are calculated using management discretion. An important point to consider here is that management bonuses are normally based on pro-forma earnings…

There are three major reasons why pro-forma earnings differ from GAAP earnings:


1. Costs deemed non-recurring: The classification of these is based on management’s own judgement. The job of the analyst is to question whether restructuring is really a one-off charge, or whether is it an integral part of an acquisitive business model? If we think it is, then we should treat the restructuring charge as a cost of doing business, and integrate this into the way we think about the company’s long-term valuation.

2. Amortisation: This is a non-cash charge applied to an intangible asset (patents, goodwill etc.), and typically relates to an asset obtained at the time of an acquisition. It is normally excluded from pro-forma earnings, and whether this is reasonable is undoubtedly the toughest nut to crack, requiring deliberation and a detailed look at the specific intangible assets in question. For example, a telecommunications operator will need to renew its spectrum licences (and therefore the cash cost of renewing the licences needs to be factored into our long-term valuation), but other assets, such as customer lists, may have an indefinite lifespan.

3. Share-based compensation: Compensation packages for management and staff often include share-based compensation such as share options. The accounting charge is an estimate of the value of these awards, but as it is a non-cash charge, it is usually excluded from pro-forma earnings. However, in my view this is potentially misleading: share-based compensation represents an ongoing cost of employment and should therefore be included.


So, to return to the original question, which number should we look at? I believe the answer could be neither.

Instead, we have to understand why the numbers are different and use our knowledge and judgement to come up with our own view.

The rigour and consistency involved in generating a proprietary P/E figure, which involves adjusting for accounting differences, capital structure and the business cycle (and thereby necessitating more work for the analyst!), should produce, in my opinion, a far fairer impression of a company’s enduring earnings potential – and one which is more comparable between sectors too.


[1] Pro-forma earnings per share are earnings that have been adjusted from regular GAAP earnings, usually by excluding costs to give what the preparer believes is a truer picture of a company’s underlying profitability.


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